What Now in Japan

by Claus Vistesen

The BOJ is holding at 0.5%, exports are booming, and capex stays afloat. So what will happen in Japan as we venture forward into 2007. Well, this is what I am trying to answer in a recent note over at GEM. Here is an exerpt from my summary.

So, on the economic outlook for Japan going forward I would especially like to stress one thing to watch, and that is the substantial risk of Japan falling back into deflation in March (and perhaps February) on a y-o-y basis. If this happens it will undoubtedly cause some ripples between the MoF and the BOJ where the latter will be accused of acting prematurely on the basis of a backward looking hike in February. The other thing is industrial production which almost inevitably fell in February on a m-o-m basis due to de-stocking on the back of the unsustainably high capex seen in Q4 2006. The evolution of the export surplus from March onwards will determine just how much capex can be ramped up in the months to come, and this again depends on how key economic data coming out of the US (and to some extent also China) evolves. On consumer spending, we should expect to see a small pick-up over the next few months on a m-o-m basis but I am not bullish about the evolution of consumer spending on a y-o-y basis.

Interestingly I might have to revisit my view on Japan slipping into deflation on a y-o-y basis on the back of a dropping headline inflation rate. As such, the headline is ticking slowly back up at the moment and since Japan includes energy in their core inflation figures this is (at least for Japan) some sort of good news. Whether it is too late is of course another story and I maintain my view that Japan will be slipping into deflation in February and March on a y-o-y basis and in the end we really need to exclude energy from Japan's price index in order to get the right picture. Also, I think that it is not necessarily a great disaster if Japan slips into deflation in February and March (I mean the headline will probably be pushing up again in the rest of 2007 unless of course the US totally crashes) but more so the internal power struggle between the MoF and the BOJ will be exacerbated and I am sure that the MoF is poised to strike at the BOJ for raising prematurely should Japan touch base with deflation.

Japan Goes To AA

by Claus Vistesen

Indeed, Japan seems to be in a very vigorous economic mood at the moment with particularly consumption figures looking healthy in Q1. Perhaps the recent upbeat performance in Q4 2006 and Q1 2007 is in part why Standard Poor chose today to raise the credit rating on Japan (i.e. government debt) from AA- to AA.

Japan's debt ratings were raised one level to AA, the third-highest grade, by Standard & Poor's after the government cut borrowing and nursed a recovery in corporate earnings.

The increase in the long-term foreign and local currency debt ratings from AA- was the first by S&P since it assigned Japan the top AAA grade in 1975. Japan was downgraded three times between February 2001 and April 2002 as economic growth stalled amid deflation and banks struggled to dispose of bad loans.

S&P today said the banking system has been restored to ``good health'' and the world's second-largest economy will grow at about 2 percent, twice the pace of growth during the decade after an asset bubble burst 16 years ago. Prime Minister Shinzo Abe's government could improve the rating further if it finds the political will to raise taxes and cut spending, S&P said.

Clearly, this indicates that Japan is on the right way towards a sustainable recovery does it not? Well, there are two aspects of this of coures. First of all we have the actual credit upgrade by S&P. I have no doubt that the credit agencies' analysis on the Japanese banking sector is true in the sense that substantial reforms have been undertaking in order to bring back the sector to kind of efficiency on the back of the slumber in the 1990s. Yet, I am also a bit surprised on the short termism displayed in the outlook on government debt and public finances. Surely the recent efforts by Abe in terms of trimming the public budget and holding off sales of bonds are important but in the longer run should we not look at a rising old age depencancy ratio in order to gauge Japan's solvency and indeed ability to sustain debt at current levels? Ah well, I won't rain on the parade here and of course credit ratings can go south again soon enough and indeed we are perhaps looking at a short term improvement in the governmental debt position, but of course it is the longer term where I am worried. On another note, Bloomberg's surveyed economists point to a quickening in inflation which might prompt the BOJ to raise rates sooner rather than later in 2007 (if at all). This should clearly be seen in a more short term perspective than the credit rating decision above but still there is a pretty clear link since rising real interest rates also meant that yen denominated debt will be more expensive to service and then we do need to look at a rising old age dependancy ratio especially if your medium to long term macroeconomic outlook on Japan includes a reversion to a balanced growth path and thus also interest rate normalization.

In general, on Japan I also want to point towards some other sources before I leave. First of all we have Takehiro Sato's recent analysis on Japan. It is a very comprehensive account and analysis I have to say so be sure to give it a quick glance. Moreover, I also stumbled upon this article in the FT today about how Japanese asset holders (both retail and institutional) is now beginning to contemplate how to make all those assets earn a reasonable rate of return. Now, the interesting thing is of course to how big an extent this will prompt capital to flow abroad from Japan's borders in the search for yield. Lastly, we have Brad Setser's recent post which takes the pulse on another aspects of capital flows from Japan, namely the carry trade which is to say this is what the discussion converges on in the comments section. In reality, Brad sets off to note the recent reserve accumulation data in different central banks, well worth a look!

Japan and the Fertility Trap - A Worst Case Scenario?

by Scott Peterson

The way I understand how a negative scenario for population dynamics could play out in Japan is as follows:

Japan has a large segment of its population that is approaching retirement. When all of those people retire, they expected to be supported by the working population which is now far too small to support the large number of retired persons. Of course, theoretically those retirees should have some significant savings since we've been informed for years that the Japanese are great savers. So the burden of supporting a large retired population with a small labor force might be delayed for a few years. On the other hand, the use of savings by the retirees forms a wave of dis-investment that could torpedo efforts to offset the shrinkage of the workforce with robotic or mechanized production(of which much has been made in the press).

Political and social division ensue. Leaving aside the options the Japanese government has for handling that situation, pretty soon thereafter members of that retired group start dying. In 2006, according to PRB.org's World Population Datasheet, there were 9 births for every 8 deaths in Japan. When the retirees start dying off, that ratio reverses and could go fairly high in the other direction, say 12 people dying for every 8 born. So massive population shrinkage ensues.

Since the population is shrinking, domestic demand naturally is shrinking as well, and therefore Japan becomes even more dependent on exports for positive GDP growth. In reality, once the ratio of births to deaths goes much below 1.0, positive GDP growth is not possible. The shrinkage in domestic demand will be too much for any increase in exports to overcome. And when the yen's value versus other currencies eventually rises to a realistic value, exports will drop off as well.

Since the population is shrinking, real estate prices decline steadily as well. So there could be a negative home equity effect on consumer spending.

Another major problem will be the large national debt built up which now will need to be covered by the output of a much smaller labor force. A default by Japan on its sovereign debt could occur.

Did I leave anything out?

Standing Fast in Japan

by Claus Vistesen

eing a BOJ watcher can indeed be a tough job in terms of forecasting but sometimes it is also pretty easy. Consequently, the BOJ chose today, pretty much as expected, to hold rates steady on the back of a return of deflation in the recent months and also I guess on the back of the outlook that deflation will persist in Q1 07 and perhaps even well into Q2 07 as well. Also of course the slowdown in the US which after all is Japan's biggest export market.

The Bank of Japan kept interest rates unchanged for a second month after consumer prices fell and recent data signaled U.S. economic growth may slow.

Governor Toshihiko Fukui and his policy board colleagues voted unanimously to hold the key overnight lending rate at 0.5 percent, the lowest among major economies, the bank said in a statement today in Tokyo. The decision was expected by all 49 economists surveyed by Bloomberg News.

Fukui later told reporters that the U.S. economy will achieve a soft landing and Japan's consumer prices will rise in the long run after hovering around zero percent in coming months. Confidence among Japan's largest manufacturers slipped from a two-year high on concern a U.S. slowdown may hurt exports, the central bank's quarterly Tankan business survey showed last week.

``There's still a pretty big chance for a rate hike later this year if the central bank can confirm Japan's growth is supported by demand at home, even if the U.S. economy deteriorates,'' said Ryutaro Kono, chief economist at BNP Paribas Securities Japan Ltd. ``We expect the bank to act in the fourth quarter.''

For more on the outlook on the Japanese economy you can check out my recent notes which also dicusses in more detail the outlook in deflation based on recent analysis by Takehiro Sato from Morgan Stanley. More interestingly, we have consumer spending which indeed has shown positive signs as of late and most likely will show a healthy growth clip y-o-y in %. However, remember still that 2006 was a below trend year in terms of consumption expenditure and that consumption expenditure is still below 100 on a real Index 100 (2005) basis. In fact the trend since 2000 is one of secular decline as shown in the figure below.

This of course does not mean that this might not signify a significant pick-up but my main worry is that deflation will entrench itself in Q2 of 2007 which could feed into expectations and since Japanese consumers already are saving a lot the pick-up in consumption expenditure will perhaps be shortlived. For sure, the chance of a y-o-y improvement is there but I do not see a change in the overall trend. Finally and on deflation I leave you with a chart plotting real GDP growth and the evolution of the GDP deflation since 2001. As you can see real GDP has picked up as of late but of course so has a the Japanese trade surplus.

On a very last note I am not chaning my main position here and the outlook on deflation still worries me most although of course the recent pickup in consumption expenditure is most welcome. In terms of interest rate decisions we should expect the G7 ministers and other high lords to pounce on Japan again come next weekend although I expect that the criticism will be less pronounced than last time. I do expect however that European G7 members and officials in particular will spend time on the Yen. However, I do not see the BOJ raising on this side of Q3 with the current outlook in deflation.

Update on Wednesday, April 11, 2007 at 03:55PM by CV

The recent data on manufacturing orders in Japan actually seems to require a revision to the downside of my call on capex spending in Japan in Q1 2007. Consequently, machine orders fell 5.2% in February which clearly suggest that exports are losing steam going into 2007 and since the US after all is the biggest export market (22%) then this might be a sign of a transmission mechanism in the works (de-coupling anyone :)?). This also means that industrial production most likely will have continued its decline in March and April on two accounts Firstly, as a result of de-stocking on the back of high capex in Q4 2006 and secondly, as a result of a real decline in foreign capacity proxied by a US slowdown and perhaps also a cooling in Chinese investment.

A second data piece on Japan which caught my eye was the news that corporate credit growth supplied by Japanese banks fell in March. The decline was, it needs to be said, ever so slight and corporate credit is still growing albeit more slowly it seems. This is of course likely to be a derivative of the points above and an indication that capex in Japan is slowing on an overall basis in the beginning of 2007.